Ecuador, Setting an Example by Adopting Digital Currency US Ecuador Setting an Example by Adopting Digital Currency Posted on 5:00 am April 5, 2015 Author Gautham Categories News , Opinion Tags Central Bank , digital currency , dollar , ecuador , Electronic Money System , EMS , Rafael Correa , South America , sucre Earlier this year, the South American nation of Ecuador became the first country in the world to have its own official digital currency. Ecuador abandoned the use of its national currency ‘ sucre ‘ in 2000 amidst the banking crisis to adopt the US dollar as the currency for transaction. Since then the country has been using dollars as the instrument of payment. The country, led by its President Rafael Correa since 2007 had announced in mid-2014 the plan of going digital with a government backed digital currency. The new digital currency system is set up to be used alongside the conventional US Dollar (Ecuador may gradually replace US dollar with digital currency). It seems like Ecuador decided to make use of a bitcoin like technology to create this digital currency so that it can benefit from all the goodness that comes associated with it.

The Ecuadorian digital dollar, now called the Electronic Money System (EMS) was announced while keeping those who can’t afford traditional banking in mind. Apart from making the country’s monetary system simplified and more efficient, it also allows poor Ecuadorian citizens to receive and send payments with their mobile phones, similar to M-Pesa and other services widely adopted in African nations. The Central Bank foresees EMS being used in the future to pay government bureaucrats in a “hygienic manner”, minimizing the possibility of corruption and graft. EMS implementation is designed to happen in three distinct phases. The first phase was live from 24 December 2014 to 25 February 2015. During this phase, people were allowed to create EMS accounts and make changes to their login credentials. In order to register to the service, all one needs is a mobile phone, proof of identity and proof of having voted in the previous elections (to ensure only Ecuador’s citizens benefit from it). The EMS adoption is currently in the second phase, allowing users to perform transactions like depositing, sending and receiving money to and from mobile wallet.

Third phase is likely to set in sometime during the end of this year where features for paying utility bills and taxes to the government will be included to EMS. The EMS has received mixed response from the citizens. By the end of first phase, the system received only 8,000 registrations. Even though people are curious about the new system, most of them are waiting for the system to be completely implemented before they can opt for it. EMS will hold monopoly for digital currency in the Ecuadorian economy as the bill authorizing the implementation of Central Bank controlled digital currency bans other digital currencies including Bitcoin. For wider adoption of EMS, the government has to conduct educational programs across the country to make people understand the concept of digital currency, its advantages and the benefits of digital currency on the country’s economy and individuals’ living standards. Ecuador has certainly set an example for rest of the world by becoming the first nation to adopt digital currency backed by the country’s Central Bank. It is just a matter of time before other nations follow suit. Published by Gautham Gautham has an eye for anything new. He has been part of multiple startups and his current project focuses towards the social good sector.

An entrepreneur, engineer and enthusiast (bitcoin, of course), he has been moonlighting as a writer for multiple publications and currently writes at NewsBTC. Find him on twitter as @gautham_n and on facebook at /gautham.nm View all posts by Gautham Using the Dollar To Hold the Line; U.S. Currency Becomes Ecuador's - The New York Times The New York Times Business Day |Using the Dollar To Hold the Line; U.S. Currency Becomes Ecuador's Search Continue reading the main story Correction Appended Even in the rest of Latin America, this country of 12 million has never been regarded as much of an economic leader. But by deciding to replace Ecuador's currency with the American dollar, President Jamil Mahuad has thrust his nation onto center stage of a heated, continent-wide debate about monetary policy and economic relations with the United States. Mr. Mahuad's unexpected move, announced on Jan. 9 amid a political crisis that threatened to topple him, is a textbook example of what economists call dollarization, and provides the test case long sought by advocates of that policy, once considered as much a fringe notion across the hemisphere as the flat tax still is in the United States.

So for the next few months, both the Clinton administration and its trading partners from Canada to Chile will be watching the experiment here intently -- and with a healthy dose of skepticism. At the moment, the only country in Latin America that uses the dollar as its currency is Panama, which took that decision almost immediately after breaking away from Colombia in 1903. Because Panama is so small and was so closely linked to the United States by the Panama Canal Zone, the rest of Latin America has traditionally viewed it as a unique and not especially attractive case in which national sovereignty was traded for stability. Continue reading the main story But the trend toward regional trading blocs, including the possibility of forming a Free Trade Area of the Americas as early as 2005, has forced a re-examination of that attitude. The success of the euro, especially as it affects the mother countries of Latin America, has also made the notion of a single currency for the hemisphere more plausible and attractive. Advertisement Continue reading the main story ''Joining the euro group has been a more secure arrangement for Spain and Portugal, with lower inflation rates'' and rapid growth, said Ricardo Hausmann, chief economist of the Inter-American Development Bank.

''If a monetary treaty can be negotiated, it could be attractive for Latin America.'' Economists and government officials say the nations that would be most tempted to follow Ecuador's example are those of Central America, which already conduct the bulk of their trade with the United States. In El Salvador, for instance, dollar remittances from Salvadorans in the United States are now the principal source of foreign exchange. In reality, many Latin American nations already rely on dollars, to one degree or another. At the checkout counters of many supermarkets in Peru, for example, the bills given to shoppers are calculated both in dollars and Peruvian soles. Customers pay in either currency. Other Latin American countries, most notably Argentina, have formally adopted mechanisms that tie the exchange rate of their pesos to the dollar and have made the two currencies fully convertible at that fixed rate. And beyond Latin America, Liberia in Africa and a few tiny island nations in the Pacific have embraced dollarization, while Hong Kong has followed an approach similar to that of Argentina and its currency board since 1983. Indeed, the consistent popularity of the currency in world markets has meant that most United States dollars can be found in other countries.

The Federal Reserve estimates that about $580 billion is in circulation globally, two-thirds outside of the United States. ''Most countries have a large amount of their debt in dollars, maintain a large percent of their reserves abroad in dollars, and write contracts indexed to the dollar,'' said a World Bank official. ''In a country like Argentina, a lot of the costs of dollarization have already been incurred, so the step to full dollarization would not be that great.'' Countries adopting the dollar ''may lose some flexibility in domestic policy issues,'' John S. Reed, the co-chairman of Citigroup, acknowledged in a speech to a Mexican bankers' group last year. But he and several other analysts argue that any relinquishing of autonomy would be offset by increased investment and capital flows and other gains. ''Full dollarization, if credible, eliminates devaluation risk, and, consequently, will likely result in interest rates which are both lower and less sensitive to crisis in other countries,'' Guillermo Calvo, director of the Center for International Economics at the University of Maryland and a former adviser to the International Monetary Fund, said in recent testimony before Congress.

''In other words, the incidence of contagion will diminish.'' Advertisement Continue reading the main story Those who advocate formal adoption of the American dollar argue that it would also benefit countries in which wage-earners are used to seeing their purchasing power eroded by high inflation and a weak currency. ''I don't know of a single worker who would complain if he were paid in dollars,'' Alberto Fernandez Garza, president of the Mexican Employers' Federation, said recently. Indeed, some analysts even suggest that dollarization could be a tool to reduce income inequality. Today, Mr. Hausmann said, ''workers are paid in pesos and executives in dollars, and workers can see the advantage of that; they want exchange-rate stability, too.'' The United States position on the issue is one that former Treasury Secretary Robert E. Rubin once described as ''agnostic.'' While the Clinton administration sees potential advantages and opportunities to extend American interests and power, it has also expressed concern about the mechanics of the process and the added burdens it might generate. Please verify you're not a robot by clicking the box. Invalid email address. Please re-enter. You must select a newsletter to subscribe to.

Sign Up Privacy Policy ''We would never put ourselves in a position where we envisioned actions that we would take would be of assistance to the rest of the world but to the detriment of the United States,'' Alan Greenspan, the chairman of the Federal Reserve, told a Congressional panel last year. To Latin American economists, that meant Washington is unwilling to extend the safety net of the Federal Reserve system to any dollarized countries that get into economic trouble. Nor would the Fed conduct monetary policy to take account of cyclical differences between Latin America and the United States. One clear benefit to the United States would come from ''seignorage'' fees that would have to be paid by countries that abandon their own currencies. Though it costs only pennies to manufacture paper bills, those notes would be sold at face value to nations adopting the dollar, resulting in a substantial profit for the American Treasury. ''By acquiring dollars for use in their domestic economies, dollarizing countries would be extending an interest-free loan to the United States,'' Treasury Secretary Lawrence H. Summers told the Senate Banking Committee last year.

If the entire region were to adopt the dollar, that would amount to several billion dollars a year, unless treaties waiving such fees could be negotiated, which Latin American countries have said they would want. In Washington on Friday, Mr. Summers said there was no likelihood of a monetary treaty or any other official accord with Ecuador regarding its dollarization. ''No formal agreement is in prospect,'' he said after a speech at the Institute for International Economics. Creating a dollar zone would also be likely to accelerate the integration of Latin American economies with the United States and create trade opportunities for American companies. ''The United States has a lot to gain, given that these countries are fertile ground for absorbing U.S. exports,'' Mr. Calvo said. Advertisement Continue reading the main story In times of conflict the United States might even be able to use the dollar as an economic weapon, withholding currency from an intractable government to bend it to Washington's will. Indeed, the Bush administration took just that step against Panama as part of its effort to overthrow Gen. Manuel Antonio Noriega. But Clinton administration officials have made it clear that given the region's long history of political and economic instability, they worry the relationship could become too close.

Dollarization in the Americas stands in sharp contrast to the experience of Europe, where a group of countries at similar levels of economic development created a new currency and established a new common central bank to manage it. ''The Federal Reserve would be buying the problems of places like Colombia and Argentina'' if those countries were to give up their own monetary system and adopt the dollar as currency, said a senior official of an international lending agency who talks often with American policy makers. ''They don't want that headache. Their attitude is 'use your own aspirin.' '' In his testimony to the Senate Banking Committee last year, Mr. Summers suggested as much, saying that ''given the political dynamics that play out in those societies at times of economic frustration,'' resentment ''could be vented at us.'' He added that if dollarization ''led to that kind of sense of eroding national responsibility, it might be unfortunate for the countries involved, and it might be unfortunate for their relationship with us.'' Though American officials have thus far refrained from saying so publicly, nothing about the way or the reasons Ecuador has dollarized makes them view it as a model. The economy here is in a deep recession, and output fell by 7.5 percent last year.

The nation's inflation was the highest in Latin America, at more than 60 percent, and in September, the Mahuad government defaulted on about half of Ecuador's $13 billion in foreign debt, not exactly a move to build confidence among investors. Not only is the country's economy in terrible shape, but the decision to dollarize was taken hastily and unilaterally, for reasons more political than economic, catching Washington and international lending agencies completely by surprise. That creates a risk that if the experiment here fails, it will damage the concept's credibility elsewhere in the region. ''Countries can obviously choose to adopt the dollar as legal tender without our assent,'' Mr. Summers said in his 1999 testimony. ''However, such a decision has some consequences for the United States, and we hope and expect that countries would consult with us in advance.'' Correction: January 19, 2000, Wednesday A chart in Business Day yesterday tracing the weakness of four Latin American currencies against the dollar carried incorrect percentage labels; it would have been impossible for Ecuador's currency to drop more than 100 percent. From Jan. 5, 1996, through Jan.

14, 2000, the Chilean currency declined 21 percent, the Brazilian currency 46 percent and the the Ecuadorean currency 88 percent; Argentina's currency was unchanged. A corrected chart appears today on Page C13. Economic Issues No. 24 -- Full Dollarization [ Conclusions ] [ Author Information ] Preface The Economic Issues Series aims to make available to a broad readership of nonspecialists some of the economic research being produced on topical issues by the International Monetary Fund. The series draws mainly from IMF Working Papers, technical papers produced by IMF staff members and visiting scholars, as well as from policy-related research papers. The following paper draws on material originally contained in IMF Working Papers 00/50 and 00/29 , respectively, "The Pros and Cons of Full Dollarization" and "The Choice of Exchange Rate Regime and Monetary Target in Highly Dollarized Economies," both by Andrew Berg and Eduardo Borensztein. Readers may purchase these papers for $10 each from IMF Publication Services. Charles S. Gardner prepared this version.

The Pros and Cons of Full Dollarization Since the end of the Bretton Woods system of fixed exchange rates nearly thirty years ago, the old dilemma facing countries of finding workable currency exchange arrangements has become more challenging, and the choices have become more varied. The decision about which exchange rate system to adopt has become more difficult as world trade and capital markets have become more integrated. New problems have emerged, and with them, new answers to the question of the best exchange regime to promote each country's development objectives. The newest of these solutions is full dollarization, under which a country officially abandons its own currency and adopts a more stable currency of another country—most commonly the U.S. dollar—as its legal tender. From the perspective of any hard currency country, full dollarization may appear more radical than it is: use of the U. S. dollar or another major currency is pervasive to one degree or another in most developing countries, particularly in financial contracts (see Box 1, "What Is Dollarization?"). Full dollarization means taking the next step, from informal, limited dollarization to full, official use of the foreign currency in all transactions.

The main attraction of full dollarization is the elimination of the risk of a sudden, sharp devaluation of the country's exchange rate. This may allow the country to reduce the risk premium attached to its international borrowing. Dollarized economies could enjoy a higher level of confidence among international investors, lower interest rate spreads on their international borrowing, reduced fiscal costs, and more investment and growth. Box 1. What Is Dollarization? This pamphlet focuses on full dollarization, or one country officially adopting the currency of another for all financial transactions, except perhaps the need for coins. In considering this choice of exchange regime, two points are important to keep in mind: The term dollarization is shorthand for the use of any foreign currency by another country. The issues it raises are identical for the other countries in the region using the South African rand, for example, and they would be for any country of, say, Eastern Europe, considering eventually adopting the euro. Most developing countries—as well as transitional economies just adopting market mechanisms—already have a limited, unofficial form of dollarization. To a greater or lesser degree, their residents already hold foreign currency and foreign currency-denominated deposits at domestic banks.

In high inflation countries, dollars or some other hard currency may be in widespread use in daily transactions, alongside the local currency. Such informal dollarization is a response to economic instability and high inflation, and the desire of residents to diversify and protect their assets from the risks of devaluation of their own currencies. It is useful to distinguish between two motives for the demand for foreign currency assets: currency substitution and asset substitution. In currency substitution foreign assets are used as money, essentially as means of payment and unit of account, and it typically arises under conditions of high inflation or hyperinflation when the high cost of using domestic currency for transactions prompts the public to look for available alternatives. Once the use of foreign currency in transactions becomes accepted, it may not be rapidly abandoned. Remarkably, the increase in dollarization in some Latin American and Asian countries has continued and accelerated in recent years even following successful stabilization. Asset substitution results from risk and return considerations about domestic and foreign assets. Historically, foreign currency-denominated assets have provided the opportunity of insuring against macroeconomic risks, such as price instability and prolonged depressions in many developing countries.

Even under conditions of current stability, foreign currency-denominated assets may still serve this purpose if residents believe there is even a small chance of inflationary relapse. Important differences exist between informal and full dollarization, presenting transitional problems for governments considering it. All government and private debt under full dollarization is denominated in dollars, and both public and private accounts must be converted to dollars. To make the conversion, countries must set the rate at which old debts, contracts, and financial assets will be converted to dollars. Finally, the stability promised by dollarization is itself relative, given that the U.S. dollar—or any other hard currency chosen for use by another country—will fluctuate in value against other widely-traded currencies. During the post-Bretton Woods period, these swings have sometimes been large. Questions About Pegs Can these advantages offset the costs of a country giving up its own currency? The answers are complex, and in the end turn on each country's specific circumstances. But more and more countries are seriously considering full dollarization as they deal with the changes in the world economy, particularly over the past 20 years.

During the inflation-plagued 1980s, much of the debate over exchange regimes for developing countries centered on the role of exchange rate "pegs". Countries generally pick from a range of possibilities, including tying their currencies to baskets of other currencies (such as those of their trading partners), indexing their currencies in some way to their own inflation rates, or even banding together in groups, as many French-speaking African nations have through currency unions tied to the French franc. In the 1990s, global inflation abated and capital mobility and the scale of capital flows increased sharply. While countries welcomed the investment flows, they faced a new threat, as speculative attacks rose in frequency and severity against currencies that capital markets viewed as vulnerable to devaluation. Generally, the victims of these currency crises were maintaining some sort of pegged exchange rate regime. Consequently, the belief began to emerge that in a world of high capital mobility, exchange rate pegs might themselves attract speculative attacks and that only extreme choices, such as a free float or a currency board were viable. The currency board regime, under which the domestic currency is fully backed by international reserves, is the strongest form of pegged exchange rate option.

Advocates of full dollarization attack both of these choices. Free floats, they argue, are not viable for many developing countries because they risk excessive exchange rate volatility. So far, only the largest developing economies, with relatively advanced financial systems, such as Korea, Brazil, and Mexico, have attempted floating. While experience is limited, these experiments have worked thus far without major disruption. Meanwhile, currency boards have fallen prey to costly speculative attacks. Argentina and Hong Kong SAR 1 , using currency boards successfully, nonetheless suffered sharp increases in interest rates and recessions in recent years as speculative attacks spread to them from other countries. The Appeal of Dollarization Against this background, then-president Carlos Menem of Argentina suggested in 1999 that Argentina adopt the U.S. dollar as the ultimate solution to its long history of difficulties with monetary and exchange rate policy. In January 2000, Ecuador, in the context of a deep economic and political crisis, adopted the U.S. dollar as its legal tender. Prominent economists have begun to argue that essentially all developing countries should dollarize, and some industrial countries have even been urged to consider it.

Partly prompted by the example of European countries giving up their currencies for the euro, some have suggested that Canada should adopt the U.S. dollar as the North American Free Trade Agreement (NAFTA) evolves. Weighing the pros and cons of full dollarization is complicated by the virtual absence of historical experiences. Panama is the only sizable country with a history of using a foreign currency—the U. S. dollar—as legal tender, and it is fairly small, and has very close historical, political, and economic links to the United States. Even if there were more country experiences to assess, they would have to be over longer periods than is usual for evaluating monetary and exchange rate options. That is because dollarization is nearly permanent, and some of its benefits can be gained only in the long run. This analysis of full dollarization compares it to its nearest competitor, the currency board. This comparison captures the main implications of dollarization and how its effects differ from those of simply adopting a very firm peg. Furthermore, if the costs and benefits of a currency board turn out to be at least equivalent to dollarization, a currency board would be a simpler and preferable alternative for a country seeking a firmly pegged exchange regime.

The differences between currency boards and dollarization are few, but important. Dollarization's key distinguishing feature is that it is permanent, or nearly so. Reversing dollarization is much more difficult than modifying or abandoning a currency board arrangement. In fact, the largest benefits claimed from dollarization derive from the credibility it carries precisely because it is nearly irreversible. And yet for some countries under particular circumstances, the irreversibility could come at a very high cost. A government adopting full dollarization gives up the revenue from the loss of seigniorage (see Box 2, What Is Seigniorage?), whereas a currency board country does not. But a dollarizing country, by completely eliminating the risk of currency devaluation, gains lower interest rates on foreign borrowing. The analysis below examines these issues in more detail. Quantifying the potential savings from lower interest rates turns out to be more complex than it first appears, but the cost of seigniorage loss can be roughly estimated. Important effects on economic stability and global financial integration resist quantification. Giving up any possibility of devaluation is costly for some countries, negligible for others. And all must consider the implications of a reduced national role in providing lender of last resort facilities and backing for their banking systems.

Is dollarization, then, a better exchange rate regime, especially for developing countries? The answer for each country depends ultimately on its own unique characteristics, but a closer look at the pros and cons of dollarization offers some general guidance. Box 2. What Is Seigniorage? The ancient concept of seigniorage as a government's profit from issuing coinage that costs less to mint than its face value is essentially the same with paper currencies: abstracting from the minor cost of printing paper money, seigniorage is simply the increase in the volume of domestic currency. Currency can be thought of as non-interest bearing debt, and the ability to issue it as a source of revenue for the monetary authorities. In addition, reserve requirements on banks may also be non-interest bearing (or be remunerated well below market rates levels) and thus contribute to seigniorage. Thus, the annual flow of seigniorage is frequently measured as the increase in base money (the sum of currency plus bank reserves). As counterpart of the issuance of currency, the central bank acquires assets that do pay interest, such as foreign currency reserves, government securities, and loans to private banks.

In a currency board system, for example, the central bank must acquire foreign reserves in an amount equal to the domestic currency issue. As a result of issuing non-interest bearing debt (currency) and holding interest-earning assets (foreign reserves, etc.) the central bank earns a gross profit, which is often also called seigniorage by central banks. The Risk Premium An immediate benefit from eliminating the risk of devaluation is reducing the country risk premium on foreign borrowing and obtaining lower interest rates for the government and private investors. Lower interest rates and more stability in international capital movements cut the cost of servicing the public debt, and encourage higher investment and economic growth. The magnitude of this potential gain is hard to measure. Argentina, now using a currency board under which the peso rate is fixed at a ratio of one-to-one to the U.S. dollar, provides a good example of the difficulties. There, a higher interest rate for borrowing in pesos than for U. S. dollars persists as evidence that lenders see a risk that the exchange rate peg will be abandoned. Yet interest rates on dollar-denominated Argentine government and private securities also exceed those on industrial countries' debt, reflecting a risk of default by the country, or sovereign risk, on those securities.

With dollarization, the interest premium owing to devaluation risk would disappear, but the premium for sovereign risk would not. Since government and the private sector can choose to borrow in foreign or domestic currency in Argentina's heavily dollarized economy, they can already eliminate the cost of devaluation risk by borrowing in dollars. The key question, then, is: would full dollarization, by eliminating currency risk, substantially reduce the default risk premium on dollar-denominated debt? Examining yields on bonds with different features can help disentangle how markets perceive sovereign, or default, risk as distinct from devaluation risk. Sovereign risk can be measured by the spread on dollar-denominated Argentine government bonds over U. S. Treasuries. This spread has tended to come down with time, but has still averaged 3.3 percentage points during 1997­98. Devaluation risk can be measured by the spread between peso- and dollar-denominated Eurobonds, which averaged 2.5 percent over the same period. Arguments exist on both sides of the question of how much of the sovereign, or default, risk to attribute to devaluation risk.

Although sovereign risk and devaluation risk move closely together, this does not establish a causal link from one to the other. In fact, it is plausible that most of both dollar and peso spreads are explained by common factors. For example, a global "flight to quality" would raise both the measured risk of default and risk of devaluation. In this case, dollarization would not help reduce dollar spreads very much. In fully dollarized Panama, for instance, the absence of currency risk does not insulate the country from swings in market sentiment toward emerging markets generally. Moreover, since movements in Panama's spreads cannot reflect devaluation risk, the implication is that at least a part of Argentina's spread also cannot be explained by currency risk alone. Devaluation risk might increase sovereign risk for several reasons. For example, governments acting to avoid currency crises may be increasing the risk of default. Mexico did this in 1994 by issuing too many dollar-denominated bonds or dollar-indexed bonds in its defense of the peso. Or a government may impose capital controls, causing other debtors to default on dollar-denominated debt, as Russia did in 1998, blocking private debtors' access to foreign currency, and preventing them from servicing their foreign debt obligations.

Conversely, devaluation may reduce default risk by improving the domestic economy and the fiscal position, as it has in the European Monetary System. Even devaluations that initially slow the economy may improve longer-term prospects and thus reduce the risk of sovereign default. Only by analyzing historical interest rate data for individual countries is it possible to get a sense of the magnitude of the reduction in the risk premium in the event of dollarization, inferring what markets assess as the probability of default on foreign debt in the absence of currency crisis risk. Seigniorage A country adopting a foreign currency as legal tender sacrifices its seigniorage, the profits accruing to the monetary authority from its right to issue currency. The immediate cost of this issuance can be significant, and it continues on an annual basis thereafter. Dollarization involves two kinds of seigniorage loss. The first is the immediate "stock" cost: as the dollar is introduced and the domestic currency withdrawn from circulation, the monetary authorities must buy back the stock of domestic currency held by the public and banks, effectively returning to them the seigniorage that had accrued over time.

Second, the monetary authorities would give up future seigniorage earnings stemming from the flow of new currency printed every year to satisfy the increase in money demand. In the case of Argentina, the first, or stock, cost of dollarization would be the redemption of about $15 billion in domestic currency held outside the central bank, or about 4.0 percent of gross domestic product (GDP). In addition, the loss of seigniorage on account of the increase in currency demand would amount to about another $1.0 billion annually, or about 0.3 percent of GDP. For countries that do not already have enough foreign reserves to buy up their domestic currency and thereby dollarize, the acquisition of the initial stock could add indirect costs. If the country lacks the credit to borrow the reserves, it would be forced to accumulate them through current account surpluses. The cost of this could be substantial in forgone investment if, as is usual for developing countries, the better policy would otherwise be to run some sustainable level of current account deficit. The United States would get more seigniorage from dollarization in other countries. There is, therefore, a case for the U.S.

authorities to share part or all of these additional seigniorage revenues with countries that adopt the U. S. dollar. A precedent exists in the arrangements between South Africa and three other states that use the rand (Lesotho, Namibia, and Swaziland). While the United States has no sharing arrangement with Panama or any other legally dollarized economy, there have been some initiatives in the U.S. Senate to consider legislation providing for seigniorage reimbursement. Stability Important as risk spreads and seigniorage are, dollarization may offer gains that, although not immediately observable, may provide larger benefits over time. In addition to raising developing countries' borrowing costs, currency crises wreak havoc on the domestic economy. In Mexico, GDP fell by 7 percent in 1995, and the Asian countries affected by currency crises witnessed recessions in the range of 7­15 percent of GDP in 1998. Most of the severely affected countries in recent crises devalued and floated their exchange rate, but even countries with currency boards such as Hong Kong SAR and Argentina suffered fierce speculative attacks that, although weathered successfully, dealt them serious economic setbacks.

Dollarization will not eliminate the risk of external crises, since investors may flee because of problems of weakness in a country's budget position or the soundness of the financial system. This sort of "debt crisis" can be as damaging as any other, and indeed, Panama has experienced several. Nevertheless, dollarization holds the promise of a steadier market sentiment as the elimination of exchange rate risk would tend to limit the incidence and magnitude of crisis and contagion episodes. Moreover, large swings in international capital flows cause sharp business cycle fluctuations in emerging economies even when they do not involve balance of payments crises. Effect on Trade and Financial Links A powerful but still longer-term argument for full, legal dollarization is that it makes economic integration easier with the rest of the world, and insulation of the domestic financial system correspondingly more difficult. Dollarization may establish a firm basis for a sound financial sector, and thus promote strong and steady economic growth. The argument here is that dollarization is perceived as an irreversible institutional change toward low inflation, fiscal responsibility, and transparency. Furthermore, dollarization may contribute to greater economic integration than otherwise would be possible with the United States, or any other country whose currency is adopted.

A number of studies have found evidence that Canadian provinces tend to be more integrated in trade volume and price level differences among themselves than with U.S. states that are closer geographically, trading in the order of twenty times more among themselves than with nearby U. S. states. The use of a common currency may thus be a vital factor in market integration, given the fairly low transaction costs and restrictions to trade across the U.S.-Canada border. Dollarization could also bring about a closer integration in financial markets. One of the most profound effects of Panama's dollarization is the close integration of its banking system with that of the United States and indeed with the rest of the world, particularly since a major liberalization in 1969–70. Exit Option With full dollarization, a country completely gives up control of monetary and exchange rate policy. This may seem identical to currency board arrangements, since a country with a currency board cannot devalue. However, there is some scope for exit from the pegged exchange rate with a currency board, if only under extreme circumstances. Indeed, the elimination of this risk of devaluation is the main purpose of full dollarization. Benefiting from Devaluation.

Large shocks, such as a big jump in world oil prices or fall in the price of an important export, may require countries to devalue. Otherwise, they must absorb these shocks through lower nominal wages and adjustments in domestic prices. Substantial recession may then be unavoidable, particularly for economies with rigid labor markets. Experiences such as departures from the gold standard and the 1994 devaluation of the CFA franc suggest that an exit option may have great value in the presence of extreme, unexpected shocks. During the Great Depression, for example, the industrial countries that fared best were those that exited earliest from the fixed exchange regime of the time—the gold standard. Argentina was one of them, suffering only a relatively minor economic setback by abandoning convertibility early, then actively stimulating the economy through monetary policy to offset the deflationary impact of capital outflows. The countries of the CFA franc zone of West and Central Africa are recent examples of states with firmly pegged currencies that have successfully devalued to overcome severe external shocks and sluggish growth. The 14-nation franc zone resembles a currency board, with a fully convertible currency and an exchange rate fixed at par with the French franc from 1948 until 1994.

From the second half of the 1980s into the early 1990s, output in the CFA franc zone stagnated as the French franc rose in value against the U.S. dollar, the CFA franc appreciated accordingly, the terms of trade deteriorated, and labor costs rose sharply. In 1994, the 14 countries resorted to a 50 percent devaluation, achieving a turnaround in higher output, exports, and investment. Finally, countries with highly credible policymakers can also be well placed to benefit from devaluation, since the increase in expectations of inflation is likely to be lower than in countries with records of loose fiscal and monetary policies. For example, the CFA franc zone devaluation caused little inflation, occurring, as it did, against a long history of exclusive reliance on internal adjustments to deal with economic shocks. Devaluations with High Cost. These examples suggest countries may pay a high price for foregoing the option to exit from a fixed exchange rate arrangement. The reverse is true where monetary policy has been poorly managed and expectations of inflation are highly sensitive to the exchange rate. In these countries, devaluation can sharply raise domestic prices, making it hard to achieve changes in the real exchange rate.

Similarly, in countries that have become so dollarized that the dollar is often the de facto unit of account, devaluation quickly raises domestic prices, again limiting the effectiveness of devaluations. In fact, these were central reasons why Argentina adopted a currency board. Countries with a high degree of financial asset dollarization have a further reason to avoid devaluation. If a country's banks or corporations receive large amounts of dollar-denominated lending, devaluation sharply worsens their balance sheets. Even if banks on-lend to domestic firms in dollars, maintaining matched risks in terms of currency on their books, they still carry a substantial currency risk. A sharp depreciation of the domestic currency would cause a large drop in revenues in dollar terms for the banks' clients, reducing their ability to service dollar debts. As the currency crises in Mexico in 1994 and East Asia in 1997 demonstrated, when there are weak banking systems and large foreign exchange exposures in the private sector, the financial health of banks and firms is at such risk following a devaluation that economic activity is severely disrupted. Thus, devaluation as a policy option may be prohibitively costly for highly dollarized economies, and moving to full dollarization would not entail the loss of an important policy tool.

Lender of Last Resort Function and Financial System Stability While full dollarization eliminates vulnerability of the banking system to the risk of devaluation, it does not eradicate all sources of banking crisis. And when they occur, full dollarization may well impair the country's lender-of-last-resort function and hence the central bank's response to financial system emergencies. The central bank's role in operating a discount window to provide short-term liquidity must here be distinguished from its role as the ultimate guarantor of the stability of the financial and payments systems in the event of a systemic bank run. Dollarization should not greatly impede the ability of the authorities to provide short-term liquidity to the system or assistance to individual banks in distress. Such facilities are available if the central bank (or its replacement) saves the necessary funds in advance or perhaps secures lines of credit with international banks. In contrast, the government loses some ability to respond to a sudden run on bank deposits throughout the entire system. In the case of a generalized loss of confidence, the authorities would be unable to guarantee the whole payments system or to fully back bank deposits.

Ultimately, the ability to print money as needed is what allows a central bank to guarantee beyond any doubt that all claims (in domestic currency) will be fully met under any circumstances. Once the ability to print money ceases to exist, limits to the lender-of-last-resort function appear.A fully dollarized country that had already spent its foreign currency reserves to redeem its stock of domestic currency might well lack the resources to respond. A Cushion for Currency Boards. Currency boards can create base money only to the extent that they accumulate reserves, so they are almost as tightly constrained as the monetary authorities would be in a dollarized economy. In important currency board cases, however, the authorities have allowed themselves some flexibility to create money that is not fully backed on the margin, partly to be able to deal with banking crises. In the case of the run on the Argentine peso during the 1995 "tequila" crisis, for example, the Argentine monetary authorities were able to partially accommodate the conversion of peso deposits into dollar deposits held abroad as well as into dollar cash. By temporarily reducing their reserve coverage of the money base, they could increase the issuance of dollar cash and provide the dollar credits the banks needed to stay afloat.

In the wake of the 1997 attack on the Hong Kong dollar, the Hong Kong Monetary Authority introduced in September 1998 a discount window to provide short-term liquidity to banks in a more flexible way and at lower cost than under previous arrangements. The new system is expected to reduce the volatility in short-term domestic interest rates. The maximum volume of rediscounts is limited, however, and the Hong Kong Monetary Authority fully backs rediscounts with foreign exchange. The scope for accommodation to bank runs in a currency board is inevitably restricted. Indeed, even without the restrictions imposed by a currency board system, the ability of a central bank to find a way out of a financial crisis by resorting to printing money alone is limited. The injection of liquidity into the banking system to keep it from defaulting on deposits may only lead to greater pressure on foreign reserves or the exchange rate. Summing up, the main pros and cons of dollarization are as follows: Advantages Dollarization avoids currency and balance of payments crises. Without a domestic currency there is no possibility of a sharp depreciation, or of sudden capital outflows motivated by fears of devaluation. A closer integration with both the global and U. S.

economies would follow from lower transaction costs and an assured stability of prices in dollar terms. By definitively rejecting the possibility of inflationary finance through dollarization, countries might also strengthen their financial institutions and create positive sentiment toward investment, both domestic and international. Disadvantages Countries are likely to be reluctant to abandon their own currencies, symbols of their nationhood, particularly in favor of those of other nations. As a practical matter, political resistance is nearly certain, and likely to be strong. From an economic point of view, the right to issue a country's currency provides its government with seigniorage revenues, which show up as central bank profits and are transferred to the government. They would be lost to dollarizing countries and gained by the United States unless it agreed to share them. A dollarizing country would relinquish any possibility of having an autonomous monetary and exchange rate policy, including the use of central bank credit to provide liquidity support to its banking system in emergencies. What is the balance of costs and benefits of full dollarization? The answers may seem frustratingly two-handed. This is inevitable, given the complexity of the issue and the current state of knowledge about it.

The potential benefits of lower interest rates and the cost of forgone seigniorage revenues can at least be estimated. But many of the most important considerations, such as the value of keeping an exit option and lender of last resort protections, are virtually unquantifiable. Which countries are likely to benefit from dollarization? The most obvious are those already highly integrated with the United States in trade and financial relations. Yet most countries in Latin America are quite different from the United States in their economic structure and would probably not benefit greatly from dollarization unless accompanied by deep market integration, as in the European Union. The current discussion centers on a different group of candidates: emerging market economies exposed to volatile capital flows but not necessarily close, in an economic sense, to the United States. For this group, the more the U.S. dollar is already used in their domestic goods and financial markets, the smaller the advantage of keeping a national currency.

For an economy that is already extremely dollarized, seigniorage revenues would be small (and the cost of purchasing the remaining stock of domestic currency also would be small), the exposures of banks and businesses would make devaluation financially risky, and the exchange rate would not serve as a policy instrument because prices would be "sticky" in dollar terms. In such cases, dollarization may offer more benefits than costs. Author Information Andrew Berg is Deputy Assistant Secretary for Latin America and East Asia at the U.S. Treasury. At the time of his research for this pamphlet, he worked in the IMF's Research Department. He has a Ph.D. in Economics from MIT, and was lead economist and head of the Mexico Task Force at the U.S. Treasury during the Mexican peso crisis. Eduardo Borensztein is Chief of the Developing Country Studies Division, Research Department of the IMF, where he has led various studies on dollarization. A Ph.D. in Economics from MIT, he has been a staff member of the IMF since 1984 where, in addition to the Research Department, he has worked in the Asian and the African Departments.

Previously, he worked for the Central Bank of Argentina, and was a senior economist at the Foundation for Economic Studies of Latin America, Buenos Aires.

Question: Since its adoption in 2000, the US dollar has been the official currency of which mainland South American nation?
Answer: ECUADOR